Euro hits 4-month high

The euro continues to rally against the U.S. dollar, as investors welcome positive developments in Europe and anticipate more easing by the Federal Reserve.

After falling to a multi-year low of $1.20 in July, the euro rose to $1.2842 on Tuesday -- its highest level since May 11.

Europe's single currency has been supported recently by hopes for bold action by the European Central Bank, which announced last week that it would make unlimited purchases of sovereign debt for governments that agree to strict conditions.

The euro is also benefiting from expectations that the German Constitutional Court will not stand in the way of Europe's new bailout fund. The court is set to rule Wednesday on a preliminary injunction that would prevent Germany from ratifying the European Stability Mechanism.

Analysts said the gains were largely being driven by short covering, when traders are forced to buy euros as they unwind bets they made on the currency declining.

As of last week, short interest in the euro fell to a net position of $16.1 billion, down from a record high of $33 billion last June, according to data from the Commodities Futures Trade Commission.

"It's short covering and broad-based optimism that we will get additional euro-positive news later in the week," said Kathy Lien, a currency strategist at BK Asset Management in New York.

In addition to the news out of Europe, traders said the euro was benefiting from the weakening U.S. dollar.

Federal Reserve chairman Ben Bernanke has signaled that the central bank is prepared to launch a third round of asset purchases, a policy known as quantitative easing, or QE3, if the U.S. economy continues to show signs of slowing.

Ben Rooney is a staff writer for CNNMoney. He covers the European debt crisis and other international finance stories, in addition to writing about stocks, bonds, investing and other Wall Street-related news. Follow Ben on Twitter: @ben_rooney